Strong Fences Make For The Best Neighbors: Conversations for Co-Founders

Managing any long-term project is already hard enough. Throw founder conflict gasoline onto that blaze and hoo-boy. It’s impossible to effectively manage production if the studio owners are infighting, politicking, and not working as a cohesive unit. Disagreements and arguments are fine, even healthy. But if the studio owners don’t have a shared vision, the path ahead will be littered with bad blood and tears. If you’re thinking about or are in the process of starting a video game company, taking some time to ask tough questions up front can save a lot of heartache.

Preface

I am not a lawyer, and this post should not be construed as legal advice. There is simply no substitute for qualified legal council. But that’s also not something that easily fits into a start-up studio’s budget. The purpose of the post is not to obviate lawyers, but to raise the types of issues you should consider. They are not the most comfortable conversations to have. But if you think these deliberations are difficult now, just think how teeth-pullingly hard they’ll be when you’re under pressure. Or if there’s money at stake. Take the time to ask the tough questions before starting a video game company .

By Reading This Post, You Will Learn:

Why agreeing to a shared set of company values is important

How to view ownership splits

An overview of the mechanics of vesting, and why they are critical

How to leverage equity agreements to protect yourself from being kicked to the curb

Agree to Norms of Conduct

Come to an agreement about your expectations of each other. Will there be core hours? Are hours flexible or rigid? Will there be a minimum number of hours everyone must work per week? Can you work remotely? How will you hold each other accountable for performance? What happens if someone is not pulling his or her weight? How much time will that person have to correct his/her behavior before the rest of the founders take action?

You should also consider your decision-making process. What amount of consensus do you need to make a big decision? A plurality? Majority? Full consensus? What about your studio’s values? Are you going to maintain some balance of your life or work until your fingers bleed? Will you take work-for-hire contracts? Can you or your co-founders pick up freelance work on the side?

Finally, come to an agreement on what intellectual property belongs to the studio, as opposed to the partners personally. Just the game in progress and related assets? Or any working prototype that any of the founders makes while a partner in the studio? Do you consider any game idea that any of the founders mentions fair game? Set a standard now, before you start contributing ideas.

A Note About Equity

The ins and outs of equity between the various corporate structures you might use (specifically LLCs and C-Corps) are beyond the scope of this post. But, simple terms, ownership of a C-Corp is divided up into shares, and while an LLCs is divided up into ownership interests. Each has its own nuances, caveats, and legal restrictions. I’m not going to address any of that here.

For the sake of conciseness, I’ll be using the terms “stake” and “ownership interest” as catchalls for the various forms of equity.

Splitting Equity

Decide how much of a stake you each have in the company. If its an even split, easy enough. But if you feel that some founders will be contributing more to the venture (either in terms of labor, funding, or skills) take that into account. Your priority is not to be equal with ownership, but equitable. If you deserve a larger stake and don’t speak up, you’re setting yourself up for bitterness or a fight down the line if money starts rolling in and you suddenly feel short-changed.

Your priority is not to be equal with ownership, but equitable.

Likewise, if you’re self-reflective and self-aware enough to acknowledge that your partners will likely put more elbow grease into the venture, consider asking for less ownership. Yes, you are compromising your upside and your control. But you’re also managing the expectations of your partners.

Also, be aware that some experienced investors may be skeptical of an even split between partners. They may view it as a sign that co-founders are unwilling or unable to have difficult conversations with each other. If you do want to do an even split, make sure it’s not just to avoid an uncomfortable discussion.

Vesting

Vesting is the process by which you gain full possession of your allotted stake in a company. So, if you fully own all of your assigned shares (for a C-Corp) or ownership interest (for an LLC), you are “fully vested”. As a start-up, you and your co-founders should establish, in writing, an agreed-upon vesting schedule. For example, you may agree to a 3-year vesting period, after which your respective stakes are fully vested. You also need to determine the rate at which you vest. In a 3-year vesting schedule, you may decide that, each quarter, another 1/12 of your stake will vest (ie, 1.5 years in, your shares will be 6/12 vested).

Another typical aspect of a vesting schedule is a “cliff”: a length of time over which no vesting occurs. But at the conclusion of the cliff, the proportion of stake equal to that time period instantly vests. For instance, take a 3-year vesting schedule with a 1-year cliff. For the first year of the venture, no-one vests. At the conclusion of that year, each member is instantly 1/3 vested. The remaining 2/3 vests over the next two years.

You and your co-founders should establish, in writing, an agreed-upon vesting schedule

The typical vesting schedules I’ve encountered, both personally and in speaking with serial entrepreneurs and investors, is a 3- or 4-year vesting period, with a 1-year cliff followed by monthly vesting:

Months 1-12

0/48 Vested

At the start of month 13

12/48 Vested

Months 13-48

+1/48 Vested per month

At the End of Month 48

48/48 Vested

Make sure you specify the date at which the vesting schedule commences. Be clear that the schedule is per person, not across the company. If someone joins the company 6 months after it starts, her vesting schedule starts at that time.

Avoiding A Monkey On Your Back: Dead Equity

Why is vesting important? Well, let’s say you want to found a game studio with 3 other developers and agree to an equal split of ownership. You and your partners start the business on a Monday and one of your partners bails on Friday.

Without an express, written vesting agreement in place, he can still claim to own 25% of the company. He can attempt to claim 25% of the studio’s profits or 25% of any acquisition price if the studio is purchased. He can also try to retain 25% of the voting rights in any decision making. All in perpetuity. All without doing another minute of work.

Shares retained by a departed owner with no obligation to sell them back is called “dead equity”, and it’s a deal breaker for investors

This is called dead equity. They only way to resolve a dead equity situation is in court or by buying back the free rider’s stake in the company.

The legal route carries the risk of a decision going against you and actually affirming the free rider’s claim. Even if you can prove that the individual didn’t do any actual work, he could still attempt to claim proportional ownership of your studio’s intellectual property.

Meanwhile, buying out their free-rider’s stake means agreeing on a price. The free-rider will have no obligation to sell and can thus ask for whatever dollar figure suits him. These headaches make dead equity a major turn-off for potential investors. They simply don’t want to put their money into a venture with that kind of liability and baggage.

Clean Breaks: Dealing With Vested Shares of Departing Owners

If you do have a vesting schedule, you still need to determine what happens if an owner departs. One approach is to agree that any unvested interest in the studio can be purchased by the company for some nominal price (eg, $0.01/share) or at cost. For example, if the departing founder invested $500 in the the studio, and 50% of her shares are unvested, the remaining founders can repurchase those unvested shares for $250.

With regard to the vested ownership, one solution is that the departing owner retains her vested ownership. But, if she has an offer for that portion of the company from an outside buyer, then the studio has the option to purchase the shares at that buyer’s price before she can sell to him. This is called Right of First Refusal. Alternatively, the agreement can stipulate that the owner cannot sell or transfer her ownership to a third party at all (accept in the case that of death). Further, the company has the right to buy back her vested stake, at the greater of fair market value or cost, at its discretion.

Another aspect of a vesting schedule that you need to consider is what happens to unvested ownership in an acquisition, merger, or IPO. The approach I’ve seen, and that I agree with, is that all unvested stakes instantly vest in the event of a liquidity event. This is called, conveniently enough, acceleration. I like this approach because it’s simple and everybody who had a hand in making the event possible gets to share in the upside.

Resources that influenced and informed this post:

Protecting Founders From Unscrupulous Vesting Schemes

Vesting agreements protect the studio from gold-bricks and derelict founders But what about protecting the individual partners from getting unceremoniously dumped and losing their shares?

Your vesting agreement should differentiate between termination for cause and termination without cause. The best way to protect the individual founders from being terminated without cause is two-fold. First, specify the requirements for termination with cause. For instance, specify that the other founders must notify the partner in question in writing that his performance is unacceptable. The written document must explain precisely why and specify the time frame that that founder has to correct his performance.

Your vesting agreement should differentiate between termination for cause and termination without cause.

Second, specify what happens when the company terminates a founder without cause. I recommend specifying that termination without cause results in instant fully vesting for the affected partner. It’s the nuclear option, if you will. The other founders cannot unceremoniously kick you to the curb without doing financial damage to themselves.

You also may have a concern about the buyback options. What if your co-founders buy-back your stake from you right before the company dramatically increase in value?

The company needs to repurchase your interest at fair market value, or (in plain English) what its worth. If the company knows of and does not disclose an impending event that would impact the value of your stake, that’s fraud, and you would have legal recourse.

Running a Blog != Law Degree

To reiterate, I am not a lawyer, so do not construe this post should as legal advice. A lawyer can iron out all of the case-specific nuances in an operating agreement that would never occur to someone without formal legal training. But discussing these kinds of topics and putting them down in writing can make life a lot easier if you need to manage a dispute later on. If you can’t afford legal council (or a LegalZoom package), you could do a lot worse than putting your own agreements in writing.

If your partnership can’t survive discussing these kinds important topics from the onset, trust me: you are better off not starting a company together. It’ll only end in tears.

Do yourselves and your future employees a favor and talk about this stuff before starting a video game company together. The conversations can be difficult, but they are vital to a healthy organization. And if your partnership can’t survive discussing these kinds important topics from the onset, trust me: you are better off not starting a company together. It’ll only end in tears.

Do you have a horror story of a studio or start-up gone wrong due to founder infighting? Let me know in the comments!

Key Takeaways

Talk with your co-founders about the logistical aspects of your proposed studio before starting a video game company together